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Why Would the Fed Choose Deflation?

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"To facilitate the government's seemingly insatiable demand for borrowing, U.S. treasuries must be made more attractive  with respect to those of other nations as well as other kinds of investments. And one way to do that in the short term is to tolerate a deflationary trend in the U.S. economy," writes the Political Calculations blog in a rather optimistic take on the present situation from a political vantage point. It's optimistic because it originates from the belief that the Federal Reserve is working hard to manage the economy's path out of the ongoing bust phase of the business cycle. The reality is that the Fed has no ability to choose any path for the U.S. economy. It's a myth assembled from an illusion.

The Federal Reserve - any central bank for that matter - IS, by definition, inflation. That is the function of the organization itself; by increasing the money supply, the central bank adds extra demand for goods without making any contribution to the production of goods and services. This money is created out of thin air, and as a consequence of that creation real wealth is slowly -- and sometimes rather quickly -- eroded. Of course, this fact is hidden by a couple of things; first, the perception that the Fed is an inflation fighter, which would be no different than calling the fire department employees "firefighters" if the fire department employees went around secretly setting the fires they later "put out," and second, by the fact that one of the main the symptoms of inflation, increasing prices for goods, services and financial assets, can for quite some time hide the fact that real wealth is being slowly eaten away.

In a central-bank-managed inflationary economy, the inevitable consequence of the deflation that necessarily follows decades of inflationary policies -- this is the point of all those Austrian economist histrionics for all these years -- is that the Fed will eventually be rendered incapable of inflating the money stock at a pace fast enough to reverse the underlying deflationary forces that take away the illusion of inflated prosperity. As we are now seeing, the longer the Fed is successful in delaying the inevitable consequences of unproductive growth and a misallocation of resources, the more severe will be the deflationary debt unwind.

Consider this:

"The government must not try to inflate again, in order to get out of the depression. For even if this reinflation succeeds, it will only sow greater trouble later on. The government must do nothing to encourage consumption, and it must not increase its own expenditures, for this will further increase the social consumption/investment ratio. In fact, cutting the government budget will improve the ratio. What the economy needs is not more consumption spending but more saving, in order to validate some of the excessive investments of the boom. Thus, what the government should do, according to the Misesian analysis of the depression, is absolutely nothing." - Murray Rothbard, Economic Depressions: Their Cause and Cure
POSITION:  No positions in stocks mentioned.